Mistaking Beta for Alpha: An Intro Into the World of Chinese Wealth Management Products

Jan 28 2014, 1:04am CST | by


This article is excerpted and adapted from “Tiger Woman on Wall Street – Winning Business Strategies from Shanghai to New York and back” published by McGrall Hill in November 2013. Copyright © 2014 by Junheng Li.

The recent turmoil in the Chinese market continues to trigger concerns over defaults among Chinese trust products. Much of this risk stems from the whirlwind increase over the past few years in wealth management products, or WMPs, a facet of shadow banking that has deeply penetrated the ranks of retail investors around the country. Many Chinese, including many friends and families I know in China, have purchased these financial products at one point in time, lured by a significantly higher yield than saving accounts.

Wealth management products (WMP) are bank generated investment products that are sold to their retail and institutional customers. Similar to money market funds, WMPs pool funds with a relatively short investment horizon (as short as five days) and invested them in longer duration assets to arbitrage the difference in returns. Disclosure on these products, including what assets they invested in and the likely returns of each, is limited. WMPs essentially circumvent China’s tight control of interest rates by rewarding investors higher returns than deposit rates.

Everbright Bank first pioneered this form of shadow banking in September 2004 as a way to attract retail deposits – the bank would require a customer to open a savings account before buying WMPs. Other banks followed suit, and competition among WMP products heated up. WMP issuance surged in 2010 as inflation accelerated; real interest rates dipped into the negative, and depositors who realized they were actually paying for the privilege of depositing their money in the bank moved money out of their savings accounts in droves. As monetary policy was tightened further in 2011, banks then scrambled to attract deposits to meet their required loan-to-deposit ratios, and WMP growth accelerated further. Ratings agency Fitch estimated that around RMB 13 trillion of WMPs were outstanding by the end of 2012, an increase of over 50% on the year.

In principle, with authorities capping deposit rates at below-market levels, the emergence of financial products that circumvent the cap and offer a higher rate of return does not necessarily compromise stability. In other words, the excess return on a WMP product over the officially controlled deposit rate does not necessarily imply the WMP product is riskier. Instead it could be a reasonable approximation of what the “real” deposit rate would be without an artificial ceiling.

However, WMP products have rapidly moved beyond that point, offering returns well in excess of an appropriate level for a deposit-like investment. Trust funds and other providers of WMP products invest their funds in high-risk projects in order to offer spectacular returns. Most investors in these products – typically, your average middle-class households – don’t realize that these returns include a significant risk premium. Like so many before them, in different times and places, these investors consider “excess returns” to be evidence of their acumen as investors – what financial pundits call “alpha” – rather than compensation for increased risk that will likely materialize at some point – what financial pundits call “beta.”

Central to the WMP structure is the pooling of investor funds. The general pool then funds a variety of assets across the risk spectrum, many in the shadow-banking sector. In other words, the average Chinese people who buy WMPs basically have no idea in what they were investing. Xiao Gang, chairman of the Bank of China, wrote a controversial op-ed in the state-run China Daily newspaper in October 2012, in which he called WMPs a Ponzi scheme. But most investors overlooked these warnings until a few WMPs started to default.

One WMP in particular became infamous. The Chinese investment vehicle known as “Zhongding” promised investors a short-term return as high as 11-17%, many times what Chinese investors typically earn on bank products. Even though the investment threshold was at least RMB 500,000, customers still flocked to the product. Huaxia Bank, which marketed the Zhongding product, provided exceptional service for the VIP clients the product targeted. Those interested in the product would be ushered into a VIP room for a pleasant conversation with the lobby manager, and only had to sign on the dotted line.

Banks sold all kinds of WMPs, but they only guaranteed roughly half of them. Many WMP investors realized this fact for the first time on November 25, 2012, when Ms. Wu, one of those well-served Zhongding investors, was told that she wouldn’t get her money back. The managing partner of the product, Tongshang Guoyin Asset Management Company, told the banks that had marketed its product that it could pay customers neither interest nor the principal. Crowds of angry investors who had bought Zhongding and other WMPs soon formed outside of Huaxia branches in Shanghai.

State media quickly painted the default as a one-off event: The press were quick to emphasize that Chengyang Wei, the one who initiated the Zhongding product, had spent seven years in prison due to financial fraud in the past. Huaxia Bank’s management was outraged, and put the blame on “a rogue salesperson” for selling those problematic products without permission from headquarters.

However, other defaults soon followed the Huaxia incident, calling into question the safety of other wealth management products. That same month, customers at a branch of China Construction Bank in the northeastern province of Jilin suffered the loss of 30% of their principal claim from a WMP. Soon after, Citic Trust Co, a unit of China’s biggest state-owned investment company, missed a bi-annual payment to investors in one of its trust products after a steel company missed interest payments on the underlying loan.

For Chinese retail investors, the lesson is clear: If something looks too good to be true, it almost surely is. The lessons for foreign investors are clear as well: listed Chinese banks are simply not suitable investments. The stocks may look cheap compared to earnings, but no one really understands what is on their books. I often called China’s economy a “black box,” but the banking sector is the darkest part of all.

Chinese banks need to be cleaned up, recapitalized and become much more transparent before they are investible. In fact, the leading American banks recently sold stake in Chinese banks. Bank of America sold part of its stake in China Construction Bank, while Goldman Sachs sold a $2.3 billion stake in Commercial Bank of China last year, following a similar sale of its holdings in Industrial and Commercial Bank of China (ICBC). The American banks claimed they were just raising cash, but I believe opacity and corporate governance issues played a major part.

The ongoing defaults of wealth management products send a clear message to investors: Understand the difference between alpha and beta, and buyer beware.

Source: Forbes Business

 
 

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